Challenges before the 15th Finance Commission

The 15th Finance commission (FC) in its interim report for the year 2020-21 has recommended the share of states in the centre’s taxes to be decreased from 42% during the 2015-20 period to 41% for 2020-21. The 1% decrease is to provide for the newly formed union territories of Jammu and Kashmir, and Ladakh from the resources of the central government.

The commission also made an observation that 14 states are estimated to face a revenue deficit post-devolution of the taxes at 41% share. To make up for this deficit, the Commission has recommended revenue deficit grants worth Rs 74,341 crore to these 14 states.  Additionally, three states (Karnataka, Mizoram, and Telangana) have been recommended special grants worth Rs 6,674 crore. The special grants are recommended to compensate for a decline in the sum of tax devolution and revenue deficit grants in 2020-21 as compared to 2019-20. However, the centre has asked the 15th FC to reconsider its recommendation as it introduces a “new principle for tax devolution”.

Similarly, in addition to the grants allocated by the Union government under Centrally Sponsored Schemes (CSS), the commission had recommended additional grants of Rs. 7,735 crore to the states for nutrition in FY 2020-21, which has also been not accepted by the centre. The centre asked the 15th FC to “review this recommendation as part of its overall proposal of measurable performance-based incentives for states, as per the Terms of Reference in the main report”.

Reading of Article 280 along with Article 281 says the recommendations of the finance commission are submitted to the president who in turn “shall cause every recommendation made by the Finance Commission under the provisions of this Constitution together with an explanatory memorandum as to the action taken thereon to be laid before each House of Parliament Miscellaneous Financial Provisions” (Article 281).

Quoting these constitutional provisions and the conventional practice being followed so far some experts have commented that the recommendations of the finance commission have to be accepted in toto by the government. However, the recommendations so far made by the 15th FC are only covering an interim period of 2020-21 and its final report is still under preparation one has to wait for the final recommendations of the commission.

15th FC has changed the formula for determining the share individual states are eligible for in order to consider what it calls “fiscal needs, equity and efficiency”; the weights assigned to the variables used in the distribution formula have also been changed.

For the first time, in addition to income distance (difference between a particular state’s per capita income and that of the richest state), population and area, and forest cover, 15th FC has used two additional factors—demographic performance and tax effort.

Table 1: Criteria for devolution (2020-21)

Criteria 14th FC (2015-20) 15th FC (2020-21)
Income Distance 50.0 45.0
Population 1971 17.5
Population 2011 10.0 15.0
Area 15.0 15.0
Forest Cover 7.5
Forest and Ecology 10.0
Demographic Performance 12.5
Tax Effort 2.5
Total 100 100

(Sources: Report for the year 2020-21, 15th Finance Commission; PRS.)

Consequent to the recommendations of the 15th FC, the tax share of most southern states, including Andhra Pradesh, Kerala, and Karnataka, has come down, while the share of Bihar, Madhya Pradesh, Punjab, Maharashtra, and Gujarat has gone up.

The major reason for Karnataka and Kerala losing out is that their per capita income growth has been much faster than most other states, thereby reducing the income distance from the highest per capita income state (Haryana). The difference from the highest per capita income in both Karnataka and Kerala is just about 10% now, as compared to 34% and 23%, respectively, for the two states when the Fourteenth Finance Commission (14th FC) made their recommendation.

Creation of Defence and Internal Security Fund

As per the additional Terms of Reference, the 15th FC has been asked to look into the creation of defence and internal security fund. The Ministry of Defence proposed following measures for this purpose: (i) setting up of a non-lapsable fund, (ii) levy of a cess, (iii) monetisation of surplus land and other assets, (iv) tax-free defence bonds, and (v) utilising proceeds of disinvestment of defence public sector undertakings.

The commission deferred taking a call on the contentious defence and internal security fund proposed by the Centre and instead constituted an expert committee comprising representatives of the Ministries of Defence, Home Affairs, and Finance look into this issue. The expert group is expected to examine these proposals or alternative funding mechanisms.

The commission’s recommendations on this issue are expected to find a place in its final report and it will be interesting to know the finance commission’s views in this regard since the subject matter of defence comes under the union list and in a way it is not within the mechanism of sharing of the taxes between the centre and the states.

Shortfall in GST Revenues

The 15th Finance Commission is also expected to deal with the mechanism of centre’s bearing the burden of shortfall in GST revenues of the states beyond 2021-2022 since as per the current GST Laws the states have been assured of an annual 14% rise over the base year 2015-16 for five year period starting from 2017-18 when the GST was introduced whereas the 15th FC recommendations for revenue sharing covers the period 2020-21 to 2024-25.

The 15th FC made the following important observations (before the COVID-19 pandemic) in its interim report.

Fiscal deficit and debt levels: The Commission noted that recommending a credible fiscal and debt trajectory roadmap is difficult due to uncertainty around the economy. It recommended that both central and state governments should focus on debt consolidation and comply with the fiscal deficit and debt levels as per their respective Fiscal Responsibility and Budget Management (FRBM) Acts.

Off-budget borrowings: The Commission observed that financing capital expenditure through off-budget borrowings is not in compliance with the FRBM. Act. It recommended that both the central and state governments should make full disclosure of extra-budgetary borrowings and the outstanding extra-budgetary liabilities should be clearly identified and eliminated in a time-bound manner.

Tax capacity: In 2018-19, the tax revenue of state governments and central government together stood at around 17.5% of GDP. The Commission noted that tax revenue is far below the estimated tax capacity of the country and it has mostly remained unchanged since the early 1990s. In contrast, tax revenue has been rising in other emerging markets. The Commission recommended: (i) broadening the tax base, (ii) streamlining tax rates, (iii) and increasing capacity and expertise of tax administration in all tiers of the government.

However, in the current scenario (post COVID-19 pandemic), fiscal consolidation will only remain as a pipedream and the centre has already enhanced the ceiling limit on fiscal deficit to the states from the existing 3% to 5% subject to complying with certain covenants.

Off budget borrowings that were an exception have become a norm of late and both the Centre and States have started using this quite frequently. CAG in its presentation to 15th FC pointed out the fiscal deficit for 2018-19 actually works out to 5.85% (the government reported a fiscal deficit of 3.46%) if the off budget borrowings to fund the capital expenditure and revenue expenditure such as food and fertilizer arrears are taken into account.

 Post COVID-19 the governments both centre and the states will have an uphill task in increasing the tax to GDP ratio due to the expected recession in the economy.

There is also a criticism that the centre frequently resorts to levying cess and surcharges that are outside the divisible pool which have increasingly become important instruments of revenue mobilisation. This criticism is supported by the factual data. Revenue mobilisation by the central government through cess and surcharge stood at Rs.3 lakh crore or 15.7 % of Centre’s gross tax revenue in 2017-18 which went up to Rs. 5.12 lakh crore in 2019-20 (BE) accounting for 21.03% of the Centre’s gross revenue.

Similarly increasing states’ contribution to core and optional schemes sponsored by the centre has certainly led to reducing states’ fiscal space.

We have to wait for the final report which is expected by 30th October, 2020 to know the 15th FCs final recommendations on the following-

1. Creation of defence and internal security fund and the modalities to mobilise the required financial resources and whether states would be having any additional burden in this since so far this has been solely under the centre’s responsibility.

2. Mechanism of centre’s bearing the burden of shortfall in GST revenues of the states beyond 2021-2022 as the FFCs recommendations cover the period up to 2024-25 whereas the GST Act currently assures the states on shortfall in GST revenues only up to 2021-22.

3. How will the 15th FC deal with the situation where the states who had in the past actively pursued family planning measures in 1970s and 80s at the behest of the then central government but now tend to loose in their share of revenue due to shifting the population base from 1971 levels to 2011 by applying the concept of both equity and efficiency.

4. The 15th FC final stand on its original recommendation in its interim report for (i)  special grants worth Rs 6,674 crore to three states (Karnataka, Mizoram, and Telangana) and (ii) additional grants of Rs 7,735 crore to the states for nutrition in FY 2020-21.

We will also have to wait for the final report of 15th FC to know how it would do an overall balancing act between fiscal needs, equity and efficiency.


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About the Author

B.N.V. Parthasarathi
Ex Senior Banker, Management and Financial Consultant, Visiting faculty at premier B Schools and Universities. E mail- [email protected]